One way for a company to raise money is through an initial public offering (IPO). It sells shares to interested investors. But once the company received the cash, why should it still be interested in the stock price? The company won’t earn more cash when the share price goes up, or the shares are sold among investors.
So why do companies have an ongoing interest in their stock price?
- Compensation of owners: The owners all have the interest to grow the business and increase its value.
- Reputation: The stock price is a reflection of the economic situation of the company.
- Shareholder satisfaction: The company needs to create value for its shareholders.
- Management compensation: The management is usually compensated through variable rates and stock options programs.
- Protection against takeovers: The management monitors the share price to protect itself against hostile takeovers.
- Recruiting skilled workers: The better the reputation of the company, the easier it will be to attract skilled workers.
Read on, to learn more about the dependency of the company to it’s stock price.
Why do companies go public and sell shares?
Companies need capital to be able to conduct their corporate business. There are two main ways that companies can raise money:
- By borrowing money from the bank
- By issuing shares (also called IPO, or going public)
If the company borrows money from the bank, it will have to pay interest for the cash borrowed and pay back the full amount after a certain time.
If the company goes public and issues shares, investors participating in the primary market can acquire these shares during the IPO. Shares are parts of ownership in the company’s equity. Therefore the company doesn’t have to repay the money or pay interest, as with a loan. However, a company can decide to pay a profit share to shareholders in the form of dividends.
Shares are a classic method of raising capital for companies if they want to grow their business, develop new business areas, or compensate for financial bottlenecks.
How is the share price created?
When a company goes public, both the company and its underwriters will establish an initial price (nominal value). The nominal value (also called the book, par, or face value) is the initial price to which investors in the primary market during the IPO can purchase the share and is usually an attractive price.
Therefore, the nominal value reflects the money the company received that went onto the balance sheet when the investors purchased the shares during the IPO.
The share price is the price to which the stock is trading after the IPO on the secondary market. The share price should not be confused with the nominal value.
The market price (share price) is the price investors think the share is worth, based on the company’s balance sheet, reputation, and future growth perspective.
The difference between nominal value and market value is the (assumed or expected) added value that the investors see in the company. The market value of the share multiplied by the number of available shares results in the company’s current market value (market capitalization).
How does the market price come about? Through supply and demand, as the number of shares that the company issues are limited.
Suppose many investors want to buy the shares, demand increases, and supply decreases. As a result, the share price rises. Conversely, the price falls if nobody wants the shares, but many shares are offered. Large supply and little demand results in a falling price.
Let’s assume a company goes public and raises one million dollars by issuing 100’000 shares. The nominal value of the share is therefore ($ 1’000’000 / 100’000) $10.
Let’s look at an example:
Let’s assume a hedge fund bought 100 shares of this company during its IPO for $10 and offers to sell the shares on the stock market for $13 per share.
An investor participating in the stock market analyzed the company’s balance sheet and future growth potential and determined that the company’s real value is at least $15 (intrinsic value), so he buys the shares at the price of $13 as he’s certain, that the price will move to at least $15, once other market participants come to the same conclusion.
If many investors want to buy the shares for $13 and are willing to offer more, the price goes up. If there are fewer investors that want to purchase the shares, the price will go down.
If the company can grow its business and increase revenue and profits over five years, it is worth more, and the share price should go up. However, investors might not realize this straight away, and this leads to market opportunities.
Why should a company care about its stock price?
The company only receives cash when it issues the shares during the initial public offering. After that, investors are trading the shares among each other.
So why are companies still interested in the share price? They don’t receive any additional money if the share price goes up or when the shares change ownership.
Companies want to grow their business
The owners and the CEO of a company are usually interested in growing the business and increasing its market share, which will increase their profits. If the business increases profits, the share price will follow, as the company will be worth more.
Companies want to have a good reputation
The stock price is a reflection of the economic situation of a company. A company’s reputation is dependent on positive company figures, such as well-filled order books, high liquidity, a healthy financing structure, increased cash flows, and profitability. These are all characteristics that investors consider before making an investment decision. A rising share price is a clear signal that this test was concluded positively. Why? High demand for a share causes the share price to rise.
The stock market is not only moved by hard facts but also by perceptions and expectations. The external perception of a company, even if it may be in crisis behind the façade, is a factor that should not be underestimated in the formation of opinions by investors, customers, and the public. Therefore having a positive image is vital for companies.
A good reputation is an incredibly effective marketing measure: customers and investors place their trust in the business. The added value through reputation will benefit the business, and through this, also the share price.
Companies want satisfied shareholders
A company goes public to generate equity by selling its shares. Investors buy shares when they have positive expectations about the stock price. The majority of shareholders will hold the share as long the share price moves in the desired direction, namely up.
Satisfied shareholders (co-entrepreneurs) are easier to maintain. They don’t cause trouble at shareholder meetings. This is important for a company because unrest and disputes always reach the public and cause reputation bumps (see the explanations on reputation). There can also be disruptions to the company’s business processes.
One of the management’s key tasks is to maximize the company’s value for the owners (shareholders). This is also known as “shareholder value”.
Compensation of senior management
Leading positions in a company from top to middle management are partially or primarily paid at variable rates, among other things, through stock options programs.
And so the share price comes into focus here as well. A high share price guarantees high compensation. In technical jargon, this is referred to as a target-oriented remuneration system. The intention is to promote motivation and identification with the company.
It is at the discretion of the company how much it pays as variable compensation. A management with more skin in the game will be incentivized and motivated for sustainable work in the corporate sense. The management’s share packages will grow year on year, both in terms of the number of shares and value with rising prices.
This is definitely a reason, albeit a very personal one, for the management to concern itself with the share price development.
A buyback of shares by the company can lead to an increase in manager income. Why? The company doesn’t need to pay a dividend on its own shares. This means that profit will be distributed among fewer shares and will therefore be higher. For shareholders, such as the management, that own a large number of shares, this can be noticeable on their account.
Protection against takeovers
A competitor or other market participant that is interested in taking over, or influencing the business (due to its business idea, brands, patents, sales structures, or qualified employees) could try to buy the majority of shares, and by this take over a large part, maybe even the majority of the company.
The competitor makes the shareholders an offer to buy their shares, which is significantly higher than the current share price to achieve his goal.
Therefore, companies usually have an eye on their share price, as the higher the share price, the more plausible it might be that someone tries a takeover. Undervalued companies can often be easy prey.
For a company to protect itself, it usually, to some level, tries to maintain its share price, which is quite limited by law. For example, the buyback of shares can help to reduce the number of shares available publicly and at the same time increase the price of the shares to the level where it will be difficult for a competitor to get sufficient value out of it.
Recruiting skilled workers
The labor market for skilled workers can be somewhat limited. Companies need skilled workers to grow their businesses. Imagine you are one of these candidates and have the choice between an innovative company with strong growth potential or a company whose business model is stagnating and no giant leaps in profit are to be expected in the foreseeable future. Which one will you choose?
Suppose a company asserts itself dynamically and globally on the markets and can face new technologies such as digitization and artificial intelligence or changed requirements. In that case, all this will be reflected in the share price, which moves to higher levels.
A company will score points with employees by being competitive and ensuring future viability. And these are the characteristics that drive a stock up.
The stock price of a company can be seen as a figurehead. If the stock price goes up, then the job is well done. The stock price goes up if the company has a positive image and can grow its business and profitability.
As Warren Buffet once said:
“If the business does well, the stock eventually follows”.